Today, corporations struggle with economic uncertainty. Maintaining profitability, cash flow and a company's vitality challenges financial managers continuously. This essay portends substantial change on the horizon, specifically surrounding lease arrangements and the dramatic impact of associated financial reporting changes. Once mandated, these modifications have the potential to negatively impact companies' long-term corporate health. Because creditors and lenders rely heavily on a company's financial reports to evaluate the corporation's financial health and borrowing capacity, business managers and accountants should prepare for potential changes impacting them. This essay will give a high level overview of the economy; then, the history and definition of corporate leasing will guide the reader to a focused discussion on lease accounting.
A Word on the Global Economy
The United States' and the global economies are powered by the growth in goods and services produced. Business investments, growth in stocks and values, investments, and trade are but a few of the factors influencing economic trends. The underpinning of economic growth is cash and investments. In the usual course of business, companies often lack readily available cash. Some will borrow funds or sell stocks; while for others, leasing provides a viable option to borrowing when growth is required. No matter the mechanism, to support their growth trajectory, corporations must add resources to meet or create supply. Growth companies, in particular, tend to be prone to poor operating performance (profitability), and are commonly limited in terms of available investment dollars. Leasing provides the opportunity for these companies to appreciate their business without impacting their balance sheet at least for today.
Customarily, leasing allows companies the option of not having to make a hard investment. As evidence of its utility, leasing is now estimated to finance some $200 billion of equipment per year in the US. What are companies leasing? The following is a short list of examples:
- Computer systems and software
- Trucks and construction equipment
- Office, medical equipment, and furniture
- Large manufacturing equipment and tools
Leasing offers financial benefits over purchasing, some of these include:
- Lower up-front cash requirements; a leased item can be acquired and used quickly.
- Limits the need for borrowed money; borrowed money limits available credit and ties up money which would produce a greater return if used in other ways.
- Provides the company to ability to maintain greater cash liquidity.
- Avoidance of owning equipment that becomes obsolete -- the lessor has the obligation to deal with getting rid of old technology.
- Known payment for which to budget; no depreciation to report.
- Leasing technology assets (depreciable) provides another source of credit.
- Advance lease payments, sometimes required, reduce future payments.
Types of Leasing
There are two main types of leases: Finance Leases and Operating Leases. The finance lease allows a company to finance the purchase of an asset, without ever acquiring the asset. The finance lease will give the lessee control over an asset for the majority of its useful life, imparting to the lessee the advantages and risks (maintenance, insurance, taxes) of ownership. The Operating Lease, which does not appear on the balance sheet, holds the owner / lessor responsible for the maintenance and upkeep. Some lease models are detailed below:
- A Lease Purchase provides the lessee an opportunity to buy the equipment at the end of the lease for a nominal fee, and become the owner who can then trade in or up. There is a fixed monthly payment, and because buyout terms are included in the original agreement, the value of the equipment is known at the end of the lease. The lease purchase allows the lessee, considered owner of the equipment, to depreciate the item. The leaseholder will record the equipment as an asset on the balance sheet and the monthly payments as liabilities.
- The Operating Lease, also known as the Fair Market Value (FMV) Lease is similar to Lease Purchase, but typically offers a buy-out at the end of lease, at a price that represents fair trade value of the equipment. The leaseholder also has the option of re-leasing or renting the equipment. The terms of this lease are usually 75% or less of the item's useful life, and the current value of the lease payments should not be greater than 90% of the FMV of the equipment -- using the lessee's established incremental borrowing costs. In contrast to the Lease Purchase, the payments on an operating lease are claimed as tax deductible operating expenses. In this case the lessor depreciates the value of the equipment, as the owner.
- Purchase upon Termination Leases (PUT), set an obligatory purchase price. A lease of this design offers a lower fixed lease payment during the term of the lease, and avoids an unknown lease-end risk for either party.
- A TRAC lease is used for "over the road" vehicles. A TRAC lease is a specific type of lease often used for costly vehicles like trucks, tractors and trailers. Residual values are predetermined but the payment deductibility benefit of a standard lease is maintained. Depreciation expense for the vehicle is recorded by the lessor (owner).
Financial professionals have available to them a framework to make prudent decisions about the use and the determination of what terms create a capital or an operating lease. The Financial Accounting Standards Board (FASB) sets reporting standards and attempts to minimize misinterpretation of the regulations. Yet, some companies continue to practice financial engineering (modified interpretation), by which they take the liberty of recording a capital lease as an operating lease. Such practices carry markedly more risk to companies today than in years past, primarily as a result of 2002 legislation driven by the Securities and Exchange Commission (SEC) . Companies must use caution in interpreting the provisions defining qualifications for capital leases, as follows.
In 2002, the Sarbanes-Oxley Act, know as SOX or SARBOX for short, was the reaction by the legislature, to numerous corporate accounting scandals involving Enron, Tyco International, and other public corporations. The legislation established new or enhanced standards for U.S. publicly-owned companies as well as for public accounting firms. As relates to leasing of equipment and capital, Title IV of the SARBOX legislation applies. The nine sections of Title IV describe the formal reports mandatory for financial transactions which include off-balance sheet transactions, pro-forma figures and stock transactions of corporate officers. Because an operating lease obligation does not appear on the balance sheet, the company with such an arrangement will appear less leveraged upon analysis. For obvious reasons, this is a favorable arrangement for the reporting company. Stringent oversight of companies' accounting practices and punitive actions for blatant or even unintentional infractions should be forefront on the minds of companies and their management teams. For further clarification, see the following from the National Real Estate Investor.
"The operating lease structure is a form of off balance sheet accounting, which means the lease obligation is not reported as a liability...
(The entire section is 3360 words.)